The Theory of Market Arbitrage Described
In business economics, finance and sports, arbitrage is the practice of taking advantage of a cost difference between two or more markets: striking a mix of matching deals that capitalize upon the imbalances, the profit being the difference within market prices.
When employed by academics, an arbitrage is usually a transaction which involves no damaging cashflow at any probabilistic or temporal state as well as a positive cashflow in a minimum of one state; basically, it’s the chance of a risk-free profit at zero cost.
In principle as well as in academic use, an arbitrage is risk-free; in common use, such as statistical arbitrage, it may mean expected profit, though losses may happen, and in practice, there are always risks in arbitrage, some minor (along the lines of change of prices decreasing profit margins), some major (including devaluation of a currency or derivative).
In academic use, an arbitrage involves taking advantage of variations in cost of a single asset or identical cash-flows; in common use, it is usually employed to focus on differences between equivalent assets (relative value or convergence trades), as in merger arbitrage.
People who practice arbitrage are called arbitrageurs possibly a bank or brokerage firm. The phrase is mainly related to trading in financial instruments, for instance bonds, stocks and shares, derivatives, goods and currencies.
Sports arbitrage has additionally recently become feasible because of the use of world-wide-web bookmakers offering up widely diverging odds on sporting events making situations where it is easy to place bets that cannot lose.
Although this involves bookmakers it is not gambling as there’s no risk on the initial stake which can not be lost. This is called ‘Arbitrage Betting‘ or ‘Matched Betting‘
Arbitrage is not simply the act of purchasing a product within a market and selling it in another for a larger price at some later time. The deals must occur simultaneously in order to avoid exposure to market risk, or perhaps the risk that prices may change on one market before both dealings are finished.
In simple terms, this can be generally only possible with securities and financial products that may be traded electronically, and even then, when each leg of this trade is carried out the prices in the market may have moved.
Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called ‘execution risk’ or more specifically ‘leg risk’.
“True” arbitrage mandates that there be no market risk included.